Beauty Contests and Iterated Expectations in Asset Markets

Posted: 29 Feb 2008

See all articles by Franklin Allen

Franklin Allen

Imperial College London

Hyun Song Shin

Bank for International Settlements (BIS)

Date Written: 2006

Abstract

In a financial market where traders are risk averse and short lived and prices are noisy, asset prices today depend on the average expectation today of tomorrow's price. Thus (iterating this relationship) the date 1 price equals the date 1 average expectation of the date 2 average expectation of the date 3 price. This will not, in general, equal the date 1 average expectation of the date 3 price. We show how this failure of the law of iterated expectations for average belief can help understand the role of higher-order beliefs in a fully rational asset pricing model.

Suggested Citation

Allen, Franklin and Shin, Hyun Song, Beauty Contests and Iterated Expectations in Asset Markets ( 2006). The Review of Financial Studies, Vol. 19, Issue 3, pp. 719-752, 2006. Available at SSRN: https://ssrn.com/abstract=1096004 or http://dx.doi.org/10.1093/rfs/hhj036

Franklin Allen (Contact Author)

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

Hyun Song Shin

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

HOME PAGE: http://www.bis.org/author/hyun_song_shin.htm

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